1. Biofuels, Energy Security, and Future Policy Alternatives Wally Tyner Purdue University

2. Ethanol Economics Ethanol has value as energy and as an additive to gasoline –The energy content is about 68% of gasoline –It has value as an octane enhancer since it has octane of 112 compared with 87 for regular gasoline The additive value has varied considerable through time, averaging 25 cents per gallon over the past 7 years – could fall to near zero

3. Policy History The US has subsidized ethanol since 1978 with a subsidy ranging between 40 and 60 cents per gallon. The current federal subsidy is 51 cents per gallon, and there are some state subsidies as well. The price of crude oil ranged between $10 and $30/bbl. between 1982 and 2003 With these crude prices, the ethanol subsidy did not put undue pressure on corn prices.

6. Corn Use for Ethanol By the end of this year about 3 bil. bu. of corn will be used to produce about 8 bil. gal. of ethanol – about 23% of the crop It could go to 4 bil. bu. in 2008 – over 30% of the crop With more corn used for ethanol, we might expect: –More corn to be produced and higher prices – already here –Less corn to be exported –Somewhat less corn to be fed –Higher price volatility

7. Future Ethanol Prospects I expect that corn ethanol will continue growing a bit, but nothing like the recent past. Future prospects depend on the prices of crude and gasoline and ethanol plus the corn price Following graphs provide one version of that future based on current capital and operating costs and futures prices for gasoline, ethanol, and corn.

11. Market Failures and Policy Alternatives Both energy security and GHG emissions are examples of situations when markets alone cannot deliver an optimal solution. Economists call these externalities, and suggest using taxes, subsidies, or some form of regulation to correct the market failure In the U.S., we do not generally use of taxes in this situation, so I will focus on subsidies and renewable fuel standards

12. Policy Alternatives Stay the course with current policy Reduce the fixed subsidy Variable subsidy Two part subsidy designed to include energy security and GHG emission reductions Special incentives for cellulose ethanol Alternative fuel standard Combination of alternative fuel standard and variable subsidy

13. Stay with Current Policy Staying with the current fixed 51 cent per gallon subsidy would likely result in markets keeping the corn price high and stimulating investment in ethanol until the corn price chokes off profitability There would be some food cost increases due to higher corn prices Global impacts are very important and quite difficult to estimate

14. Variable Subsidy The energy security externality can be handled through either a fixed or variable subsidy. A subsidy that varies with the price of crude oil would be a means of reducing the cost of the government subsidy while still providing a safety net if crude oil prices fall significantly The variable subsidy has two parameters: –Crude price at which it begins ($60) –Increase in the subsidy for each $1 crude falls below that price (2.5 cents/$)

16. Two-Part Subsidy To handle both the energy security and global warming issues, we could have a subsidy that incorporated both According to Hill and Tilman, corn ethanol reduces GHG 12.4%, soy biodiesel 40.5%, and cellulose ethanol as much as 275%, depending on production conditions.

17. Two-Part Subsidy Biodiesel contains 1.5 times the energy of ethanol, so it would receive an energy security credit 1.5 times ethanol based on imported oil displaced. The next chart illustrates how such a two part subsidy might work with components for each fuel for energy security and GHG reductions

19. Cellulose Ethanol Incentives One of the issues with our current system is that investors will continue to prefer corn ethanol over cellulose because cellulose is riskier We may need to consider other options for cellulose ethanol at the beginning to stimulate investment: –Investment guarantees or purchase contracts (reverse auction) –Tax credits to ethanol producers for each ton of cellulose used to produce ethanol or other liquid fuel

20. Alternative Fuel Standard In his State of the Union message, the President proposed a 35 billion gallon alternative fuel standard by 2017. The Senate passed 36 bil. By 2022: –Current production is about 5.3 billion –Seven fold increase in 10-15 years The administration estimates this would replace 15% of projected 2017 gasoline consumption With a binding mandate in place, it would no longer be necessary to subsidize alternative fuels

21. Difference Between a Fuel Standard and a Subsidy The fundamental difference between a fuel standard and a subsidy is who pays: –With a subsidy, the taxpayers pay the tax credits received by fuel blenders – it is part of the government budget –With a fuel standard, consumers see changes in prices at the pump depending on what the alternative fuel costs relative to gasoline from crude oil If we wanted to capture the higher GHG impacts of cellulose ethanol, the standard would need to be partitioned with cellulose receiving a higher proportion

23. Combination of Fuel Standard and Variable Subsidy An iron-clad fuel standard may be difficult to legislate, yet potential investors need some assurance the standard will hold The fuel standard combined with a variable subsidy might be a viable option

25. Policy Impacts The current subsidy can lead to very high corn prices – beneficial to corn farmers but not to livestock producers or consumers With this year’s ethanol production at 8 bil. gal., the subsidy will cost $4 bil., but CBO estimated in January that commodity payments will fall $4 bil. in 2007 The variable subsidy, two-part subsidy, targeted cellulosic subsidies, or alternative fuel mandates are options Various combinations of these options could be evaluated

26. Summing Up Today’s high oil prices are largely demand driven Global recession could lead to significant oil price drops Investments in alternative energy sources are risky in the face of future potential price falls without policy measures that insure against major price drops If we want to reduce dependence on foreign oil, we must develop policy pathways that will lead us towards greater reliance on alternative energy The policy choices we make will be critical

27. Thanks very much! Questions and Comments For more information: http://www.ces.purdue.edu/bioenergy

28. Differences Between Purdue and Iowa State Numbers Purdue assumes an additive value of 35 cents; Iowa State assumes zero Purdue varies DDGS price with corn price; Iowa State has constant DDGS price Purdue uses ethanol yield of 2.65; Iowa State uses 3.0 gal./bu. Purdue has higher capital and operating costs than Iowa State